Previously futures and options contracts were settled on a cash basis. In this kind of settlement procedure, the seller or the purchaser had to settle their position in cash. This would have to be done without any actual delivery of the underlying security specified by the expiry date of the contract. Nonetheless, as per a circular issued by the Securities and Exchange Board of India (SEBI), dated April 2018, the physical settlement of options and futures contracts is mandatory if the circumstances allow (for futures and options contracts in which physical delivery may be applicable on the date of expiry).
What is the physical settlement of options?
What is the physical settlement of options and futures contracts? You may have already understood that futures and options contracts give rights to investors to buy or sell a certain amount of an underlying asset by an expiry date. In options contracts, the buyer or seller has the right to buy or sell by the date of expiry but is under no obligation to do so. On the other hand, in futures contracts, the buyer or seller has the right to buy or sell and is under the obligation to do so by a predetermined expiry date.
Now, coming to the explanation of the physical settlement of options contracts, the date of expiry is important. On the expiry date of an options contract, the actual physical delivery of the commodity, or stocks, has to be made in any investor’s demat account and not in cash.
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Understand Physical Delivery with an Example
With SEBI making it compulsory for every futures and options contract to be physically settled if the underlying asset includes stocks, the physical delivery of the asset must take place on the date of expiry of such contracts. The main objective of SEBI in establishing this regulation is to put limits on excessive speculation, which often resulted in making the stocks in any contract very volatile.
Under the system of physical settlement, if stocks are the underlying asset in any options contract, the seller must deliver stocks and cannot settle the options contract by the transfer of cash according to the price difference between the contract’s strike price (the price at which the asset may be bought or sold as specified in the contract) and the current market price of the stocks. This may make you understand how the physical settlement of options works.
How does physical settlement take place?
Going a bit further with the physical settlement of options contracts, or the physical delivery of options contracts, you should keep a single thing in mind. The seller must physically deliver stocks to the buyer when the expiration date arrives. Note that the following transactions may occur:
- Giving Delivery: If you are the seller in an option contract, you have to give physical delivery of the stocks to the purchaser of the contract when the date of expiry arrives. The stocks get debited from your demat account. They are then credited to the Demat account of the purchaser.
- Taking Delivery: If you are the buyer in an option contract, then you must take the physical delivery of the stocks which get credited to your demat account.
The Advantages of Physical Settlement of Options
There are some benefits of the physical settlement of options and these are highlighted below:
- The physical settlement of options is subject to negligible if any, manipulation. The trade and the procedure of physical settlement are monitored by the brokerage and the clearing exchange. There is very little room for error.
- The physical settlement of options allows for the physical visibility of the stocks (the underlying asset), permitting a more transparent way of handling such transactions with price discovery in consideration.
- The physical settlement/delivery process is simple and quick. Most of the work is done by a broker, so investors are not compelled to involve themselves with tedious transactions. On the investor’s part, the whole process is effortless.
Easy Processes, Easy Investing
In earlier times, equity derivatives used to face a high degree of manipulation due to speculation. Speculators, in actuality, are traders who estimate the future price of stocks according to different factors and monitor prices regularly. Say, if any of these speculators thought the price of a certain asset would rise, they would purchase a derivatives contract pertaining to that particular asset, selling it at the expiry time to make a profit. These speculators were not keen on getting delivery of stocks, so prices of the stock faced some volatility.
Now if you wish to trade in futures and options, you should open a Demat account with an established broker like Motilal Oswal. You can sit back with ease as you get a physical settlement of options. With physical settlements, sellers can ensure that buyers have to take delivery of stocks. Furthermore, transactions take place transparently with sellers getting total amounts based on the value of contracts. While you explore derivatives, remember to do your background research and look into an upcoming IPO for portfolio diversification.